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The Term Structure with Semi-credible Targeting

Authors

  • Heber Farnsworth,

  • Richard Bass

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    • Farnsworth is from Washington University in St. Louis and Bass is from the University of Connecticut. This paper has benefitted from useful comments from Kerry Back, Pierre Collin-Dufresne, Greg Duffee, Darrell Duffie, Phil Dybvig, Bob Goldstein, Ken Singleton, Richard Stanton, Daniel Thornton, two anonymous referees, and seminar participants at Brigham Young University, Stanford University, Washington University in St. Louis, Wharton, the 1999 Utah Winter Finance Conference, and the 1999 Western Finance Association annual meetings. All remaining errors are ours alone.


ABSTRACT

The Federal Reserve sets targets for interest rates which it enforces through direct market intervention. These targets are changed periodically. In this paper, we develop a term structure model in which the short rate is subject to a control which keeps it close to a target which changes from time to time. The probability of target changes is not constant in the model, but changes as a function of observables. The model performs well at explaining the shifts in the yield curve that accompany target changes.

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